Relative Scarcity of Commodities with a Long-Term Economic Relationship and the Correlation of Futures Returns
AbstractThis paper finds that the long-term co-movement of commodity prices is driven by economic relationships, such as production, substitution, and complementary relationships. Such relationships imply that the convenience yield of a given commodity depends on its relative scarcity with respect to associated commodities. The economic linkage between two commodities creates a new source of positive correlation between the futures returns of both commodities. We build an empirical, multi-commodity maximal affine model that allows the convenience yield of a commodity to depend on its relative scarcity. We estimate the model using three commodity pairs: heating oil-crude oil, WTI-Brent crude oil and heating oil-gasoline. Our model allows for a flexible correlation term structure of futures returns that matches the upward-sloping patterns observed in the data. The high long-term correlation implied by an economic relationship reduces the volatility of the spread between commodities, which implies lower spread option prices. An out-of-sample test using short-maturity crack spread options data shows that our model considerably reduces the negative bias generated by traditional models.
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Bibliographic InfoPaper provided by Instituto de Economia. Pontificia Universidad Católica de Chile. in its series Documentos de Trabajo with number 404.
Date of creation: 2011
Date of revision:
Relative scarcity; correlation term structure; futures returns; long-term economic relation-ships; convenience yield; feedback effect; multi-commodity maximal affine; spread option;
Find related papers by JEL classification:
- C0 - Mathematical and Quantitative Methods - - General
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- E2 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment
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